Publié le 8 mars 2016 | par Nathalie Mourlot0
The new IFRS 16: a huge undertaking for the leasing industry!
Following years of debate, the International Accounting Standards Board (IASB) has just issued the new IFRS 16 on leases. Applicable for accounting periods beginning on or after 1 January 2019, it will potentially have major impacts on group balance sheets and require significant work in advance of implementation to identify all group company leases. Ultimately, it could also affect negotiations on, and the structuring of, commercial leases.
First, let’s remind ourselves of the current lease accounting principles. Under IAS 17, there were different accounting treatment for operating leases and finance leases. A finance lease is a lease that transfers substantially all the risks and rewards to the lessee of an asset. Basically, it is usually either a lease with an option to purchase the asset at a price that is expected to be sufficiently lower than the fair value at the date the option becomes exercisable, a long-term lease (the term reflecting the major part of the economic life of the asset) or a lease in respect of which the present value of the lease payments is approximately equal to the value of the asset concerned.
Although in the case of operating leases, accounting under IFRS is the same as for French individual company financial statements, i.e. a lease charge in the income statement, the treatment of finance leases is totally different. The leased asset is recognised as an asset on the balance sheet with a corresponding liability for the lease payments. In the income statement, the lease charge is replaced by the depreciation charges in respect of the asset and the interest expense. Although this treatment improves EBITDA, it also has the disadvantage of increasing net debt.
This distinction between the two types of leases, which is based on criteria which leave some room for interpretation, has resulted in a number of off-balance sheet arrangements. The approach for a group involves structuring its leases in such a way that they can be classified as operating leases, or even selling assets it owns and leasing them back under operating leases, which has the added advantage of generating a capital gain. The IASB, which is well aware of this type of arrangement, also considers that an operating lease gives the right to use an asset in exchange for an obligation to make lease payments, and should therefore by its nature be recognised on the balance sheet. This is also the approach adopted by analysts, who restate financial statements to include operating leases.
The IASB therefore began revisiting IAS 17 back in 2006, setting up a discussion group on the subject including users, standard setters and auditors. There followed an initial discussion paper in March 2009 and then an exposure draft (draft standard) in August 2010, which received considerable and intense criticism. All those involved, including those in favour of the new approach, were very concerned about the complexity of its implementation and the high degree of estimation it would involve. Additional discussions took place and, in May 2013, a new exposure draft was published, which also received considerable criticism from companies who could see no advantages over the current IAS 17, nor any benefit as regards comparability between companies. The IASB received and analysed nearly 1,700 comments on these two exposure drafts.
So what did these exposure drafts propose? Quite simply the end of the operating lease/finance lease distinction and the systematic recognition on the balance sheet of all leases, in the form of a right-of-use asset with a corresponding lease liability representing the obligation to make lease payments.
Why so much criticism? Mainly due to the difficulty with implementation: companies would have to develop tools for monitoring leases enabling the centralisation of lease agreements and the assessment of their characteristics, in particular the probable lease term.
Has the IASB taken these criticisms into account in its new IFRS 16? The lessor’s position as set out in the initial exposure drafts, despite having undergone a comprehensive review, has ended up virtually unchanged from the current position. This is not, however, the case as regards the lessee’s position: lessees will have to recognise all leases in their balance sheets as from 2019. The only concessions made by the IASB relate to leases with a short term (less than 12 months) and leases in respect of assets with a low value (less than USD 5,000).
How is the lease payment debt to be estimated? As the amount, discounted over the lease term, of all the lease payments including the variable portion based on an index or rate, as well as the amounts payable in respect of residual value guarantees, the exercise price of the purchase option (if exercise of that option by the lessee is reasonably certain) and any exit penalties. The discount rate to be used is the rate implicit in the lease or, failing that, the lessee’s incremental borrowing rate. The lease term corresponds to the non-cancellable period plus periods covered by an extension option, if exercise of that option by the lessee is reasonably certain. This therefore necessitates a lease-by-lease analysis to determine the various components of the calculation: term, lease payments and discount rate. It is therefore easy to understand the difficulties facing groups, which will have to quickly put in place the means to identify and analyse all of their leases.
There is also a risk that lessees will change their strategy during lease negotiations. The current practice of negotiating lower lease payments or a grace period in return for a longer fixed term will be abandoned in favour of shorter leases, even if this results in higher lease payments, the term having a significant impact on the valuation of the liability. In certain circumstances and, in particular, in the case of long-term activities, the leasing strategy could even be abandoned in favour of the outright acquisition of assets. Lastly, sale and leaseback transactions become less attractive in terms of balance sheet presentation, since if the entity concerned cannot prove that the transaction does indeed constitute a sale (within the meaning of the new IFRS 15), the underlying asset will continue to be recognised on the balance sheet and the amount received regarded as financing.
As we have just seen, IFRS 16 risks affecting relations between lessors and lessees for years to come. In addition, although it removes the distinction between operating leases and finance leases, it creates a further distinction with the differentiation between leases and service contracts. Indeed, amounts payable under service contracts will continue to be recognised as an expense in the income statement. Of course the IASB wanted to guard against any confusion between the two types of contract and has produced a very precise definition of the characteristics of the lease, which is defined as the provision of a specific asset whose use is controlled by the lessee. Let’s take one of the examples provided to illustrate this distinction: a three-year concession arrangement covering a coffee shop in an airport. The contract specifies the sales area and indicates that it must be located in the boarding area, but reserves the right to amend the location: any such relocation could be carried out at low cost because various locations are available. Since in this case there is no specifically identified asset, the agreement is a service contract that will not therefore be recognised on the balance sheet. The example cannot necessarily be extended to a contract in respect of a location in a shopping centre since the lessor must have an interest in relocating the lessee and it must be possible for said relocation to be carried out under satisfactory conditions and at low cost.
Is there a risk, however, that contracts will no longer be structured so that they are classified as finance leases but so that they are classified as service contracts? Or at least so that they have a significant component that could be classified as a service contract and therefore recognised separately in the income statement?
Only time will tell, but in the meantime companies will, over the next two years, have to undertake significant identification and analysis work, which will have to be carried out as quickly as possible to enable them to arrive at an accurate assessment of the impacts of IFRS 16 on their financial statements.